A Parent Burned by Incentives, Microcosm of Finance and Society?
In today’s WSJ, there’s a review of a new book called Parentonomics: An Economist Dad Looks at Parenting, in the mold of the excellent book Freakonomics: A Rogue Economist Explores the Hidden Side of Everything.
Who is ready to write “Deming-nomics: A Statistician Implores Us to Eliminate Incentives and Substitute Leadership”?
In Parentonomics, there’s a story that shouldn’t surprise any Deming disciple:
Incentives may work, but they sometimes lead to unexpected consequences, such as the time Mr. Gans implemented a point system to, uh, incentivize one of his children to make it through the night with a dry diaper. The little one — child of an economist, remember — naturally took the diaper off before going to sleep. The bedding was soaked, but the diaper was immaculate.
Classic “gaming the system” behavior. Children are clever… they learn to blame people (it comes naturally to them, actually) and they learn to game the system to get their prize.
So this brings me back to an article I was going to blog about a few weeks ago, a WSJ piece that blames performance bonuses and incentives for our financial collapse.
Again, if we had only listened to Dr. Deming:
It is merely this: That Wall Street’s compensation system isn’t just aesthetically displeasing to liberal snobs. It is the very heart of the problem. According to Bill Black, a professor of economics and law at the University of Missouri-Kansas City and an authority on dysfunctional financial systems, “It is the compensation system that has proved to be the weak point in everything critical that went wrong, that has produced a global catastrophe.”
At each stage of the disaster, Mr. Black told me — loan officers, real-estate appraisers, accountants, bond ratings agencies — it was pay-for-performance systems that “sent them wrong.”
This recession/crisis/near-depression has clearly been “made made” due to excesses and fraud in the financial sector, and it’s dragging down the world economy. Thanks, guys.
As the WSJ piece continues:
The need for new compensation rules is most urgent at failed banks. This is not merely because is would make for good PR, but because lavish executive bonuses sometimes create an incentive to hide losses, to take crazy risks, and even, according to Mr. Black, to “loot the place through seemingly normal corporate mechanisms.” This is why, he continues, it is “essential to redesign and limit executive compensation when regulating failed or failing banks.”
This WSJ article from Friday perfectly highlights the skewed risk/reward balance in Wall Street gambling, I mean “investing.” When you bet big with other people’s money and win, you get a huge payout. Short-term thinking, short-term rewards. Then, when you lose big, you lose nothing personally and get to start a hedge fund (who would give that guy money now?).
So President Obama has demanded caps on executive pay for firms that receive federal bailout money, limiting pay to $500k a year, which is more than the President makes (well, all of the Air Force One time doesn’t count as taxable income, right Sen. Daschle?).
There’s always a way around the system…. the WSJ reported yesterday that banks and companies will just be creative in paying their executives. They’ll do deferred compensation, restricted stock, and even using the loophole that the top leaders won’t technically be officers of the company. Where there’s a will there’s a way. If you want to ship contaminated peanut products, all of the government oversight and rules won’t stop you. If you want to overpay executives, the government can’t stop that, either.
It’s a shame that decency, ethics, and common sense long ago left the building. It’s like these finance geniuses took off their diapers and, well, you know…